1. Execute an Exclusivity Agreement. The entrepreneur buyer's first step in
connection with an acquisitionshould be to execute a tightly-drafted exclusivity (or "no-
shop") agreement, granting it the exclusive right for a period of time (e.g.,90 days) to
negotiate with the seller/target and to complete its due-diligence investigation. Such an
agreement is oftenpart of the letter of intent (the "LOI"); however, from the buyer's
perspective, it may be preferable, as discussed below, to execute a separate letter
agreement and skip the LOI. Indeed, if the buyer executes an exclusivity agreement with
the target early on, it canavoid (i) getting into a bidding war with other prospective
buyers and (ii) spending significant time, money and resources ondue diligence without
any assurance that the seller will not strike a deal with another party.
2. Avoid Negotiating the Material Terms in anLOI. Other thanwith respect to
a no-shop provision (discussed above) and a Hart-Scott-Rodino filing (discussed below),
there are generally no significant benefits to the buyer in executing an LOI. Indeed,the
seller's negotiating leverage is strongest priorto the execution of an LOI -- particularly if
the target is represented by an investment banker who has effectively created a
competitive selling environment (or the perception of same) -- and thus it is in the seller's
interest (not the buyer's) to negotiate the material terms of the deal in the LOI. The buyer
can avoid this trap inone of two ways: (i) byexecuting an exclusivity letter agreement
and skipping the negotiation of anLOI -- i.e., proceeding directly to the negotiationand
executionof a definitive acquisition agreement; or (ii) byexecuting an LOI that includes
a binding no-shop provision, but is otherwise non-binding (except perhaps with respect to
expense reimbursement and/or other "special" provisions) and is as non-specific/general
as possible (e.g., "this lettersummarizes a proposalpursuant to which the Buyer would
acquire the Target"). Either approach gives the buyer not only strong negotiating
leverage, but also thetime and flexibilityto complete its due-diligence investigation prior
to agreeing to any materialterms. Moreover, it will minimize the risk that the LOI will
be construed as a binding agreement between the parties --the major reason why a buyer
should be circumspect with respect to the execution of an LOI -- leading to potential
damages if the transaction is not consummated. (Note: an LOI does serve a useful
purpose in deals greater than approximately $60 million-- i.e., it enables the parties to
make any required filing under the Hart-Scott-Rodino Antitrust Improvements Act of
1976.)
3. Do Your Diligence. A comprehensive due-diligence investigation is critical to
the success of any acquisition. The fundamental purpose of due diligence is to validate
assumptions with respect to valuation and to identify risks. Accordingly, there are
typicallythree separate investigations: operational/strategic, financialand legal. Clearly,
the scope of the investigations must be tailored to the particular transaction; however, it
cannot be emphasized enough that most deals fail due to inadequate diligence -- resulting
- 2- inthe buyer (i) overpaying for the target,(ii) assuming significant unknown liabilities
and/or (iii) experiencing major integration problems. As I witnessed first-hand at two
major New York law firms, the best acquirors spend an extraordinary amount of time in
the field (not in the data room) interviewing customers, suppliers, competitors, creditors
and, of course, management in order toobtaina deep understanding of the target's value
drivers and business risks. They also demonstrate extraordinary discipline and will walk
away from a deal (regardless of the time and money spent) if they determine that they are
overpaying and/or certain significant risks cannot be contained. In short, adequate
diligence (coupled with rigorous analysis) is key.
4. Buy Assets, Not Stock (Equity). It is generallyadvantageous for an acquiror
of a private company to purchase assets, not equity, of the target for two principal
reasons: (i) it willget a stepped-up tax basis in the acquired assets; and (ii) it will
minimize the assumption of any unwanted liabilities. Indeed, in a stocktransactionor
merger, the buyer assumes all of the target's liabilities by operation of law; in an asset
transaction, however, the buyer only assumes those liabilities that are expresslyagreed to
inthe acquisition agreement. There are nevertheless certain liabilities that, regardless of
the asset-purchase structure, will be assumed bythe buyer under the doctrine of
"successor liability" as a matterof public policy, the most significant of which include (i)
products liability, (ii) environmental liability, (iii) "bulk sales" laws and (iv) certain
employee benefits and labor issues. Accordingly, the buyer must protect itself in the
acquisition agreement against such liabilities with carefully-drafted indemnification
provisions. The buyer must also protect itself in an asset deal against a fraudulent
conveyance claim by the target's creditors byrequiring that (i) the sale proceeds stay with
(or be used for the benefit of) the target and not be distributed to the target's stockholders
and/or (ii) adequate arrangements are made to pay-off the target's creditors. Needless to
say, every deal is different and must be structured and negotiated with the assistance of
competent counsel, including tax counsel; however, the buyer entrepreneur should always
be thinking about cherry-picking assets (with the caveats discussed above).
5. Tailor the Acquisition Agreement to the Particular Transaction. The buyer's initial draft of the acquisition agreement must be tailored to the particular transaction. Indeed, this is not the time for the buyer's counsel to use some off-the-shelf form (or "the agreement we used on that other deal"), with new names inserted. Instead,the initial draft should reflect ongoing substantive discussions among members of the buyer's transaction team regarding risk allocation, purchase price considerations, the diligence
findings and the overall negotiating strategy. The buyer's counsel must, for example, specificallydiscuss with his client how aggressive the initial draft should be. Perhaps from the buyer's standpoint,the purchase price is so good and anysignificant risks deemed to be remote(or containable) that the buyer wants a "seller-friendly" (or "middle-of-the road") draft to avoid losing the deal. On the other hand, perhaps the
target has so many potential problems, and the buyer perceives it is paying a full purchase price, that the agreement must be aggressively drafted, withbroad representations and warranties and indemnification obligations of the seller to protect the buyer. Needless to say, the role the buyer's counsel plays is critical: he must understand the target's business and the significant deal risks in order to protect the buyer and to ensure that the buyer is- 3- making an informed judgment with respect to price and terms. Deals often take on a life of their own-- with emotions and egos involved --and there is nothing more important on the buy-side than a lawyer who is watching his client's back.
6. Escrow a Portion of the Purchase Price. One step the buyer can take to
protect itself is to escrow a portion of the purchase price (e.g., 15-20%) for a period of
time post-closing (e.g., 18-24months). Indeed, escrows are relatively common
(particularly where there are multiple sellers) because of the inherent unfairness of
requiring the buyer to sue the seller(s) to try to get some of its money back for a problem
or liability it never agreed to take on. Alternatively, the buyer can push for a hold-back
(i.e., a right to hold part of the purchase price) and/or a right of set-off in deals where part
of the purchase price has been deferred (e.g., where the buyer has issued a promissory
note to the seller as part of the purchase price); however, escrows are obviously more
amenable to sellers (i.e., less controversial) because the money is held by an independent
third party and the buyer does not have the unilateral right to withhold payment. A few
important points worth noting in connection with escrows: (1) the buyer should avoid
limiting its recourse solely to the escrow without any carve-outs unless it is completely
comfortable with the size of the escrow and has otherwise made an informed judgment
with respect to the significant dealrisks and terms; (2)the old pooling-accounting
requirementsof limiting escrows to 10% of the purchase price and one year in duration
are no longer applicable; and (3) where there are multiple sellers, the buyer should
require the sellers to appoint a representative who is authorized to make all decisions
relative to the escrow (as well as other substantive issues).
7. Use Earn-Outs Only As a Last Resort . Earn-outs(i.e., post-closing contingency payments) are often touted byunsophisticated investment bankers and counselas an effective way to bridge the gap between what the buyer is willing to pay for a business and the seller's asking price. The reality, however, is that earn-outs often lead to major disputes and business problems post-closing and should, accordingly, be avoided ifat allpossible. On the legal side, a number of critical issues must be negotiated, including the following: (i) the metric (e.g., revenue, EBITDA, profit, etc.) and milestones, (ii) measurement/accounting issues, (iii) exclusions/carve-outs (e.g., allocation of administrative or general overhead expenses, intercompany transactions and charges, etc.),(iv) the duration of the earn-out period, (v) the effect of
acquisitions/dispositions relating to the acquired business and (vi) most significantly, post-closing operational control issues. The amount of time and energy that is required to address adequatelythe foregoing issues can be extraordinary (often leading to pages and pages of provisions), and there willstillbe gaps because it is virtually impossible to anticipate every post-closing contingency. On the business side, earnouts usually create significant impediments to the integration process and conflicting interests between the buyer and thetarget post-closing -- e.g., if the metric is revenue growth,thetarget may sign-up a number of new customer contracts that may not be profitable or in the best long-term interest of the business; if the metric is profit or EBITDA, thetarget may cut back on capital expenditures or other expenses (such as marketing oradvertising) -- particularly as the end of the earn-out period approaches. Moreover, target management may lose its motivation if it is unable to achieve its goals and thus is never entitled to an
- 4- earn-out payment. The bottom line is that earn-outs are very tricky from both a legal and business perspective and should only be used as a last resort.
8. Include a Carefully-Drafted "MAC". From the buy-side, one of the most
important representation and warranty of the seller (and closing condition ifthere is a
signing and a subsequent closing) is that the business has not suffered a material adverse
change ("MAC"). Lawyers have a field day wordsmithing the definition of MAC --
arguing over such issues as (i) the applicable period, (ii) whether "prospects" should be
included, (iii) whether the target and its subsidiaries should be "taken as a whole" and
(iv) of course, the exceptions. The bottom line, however, is that most MAC definitions
are extremely ambiguous, and there is little case law to provide any guidance as to what
constitutes a MAC. Moreover,the leading Delaware case, IBP, Inc. v. Tyson Foods, Inc.,
suggests that the standard as to what constitutes a MAC is quite high, "measured in years,
rather than months." Accordingly, the buyer must be very careful about relying on a
MAC to terminate an acquisitionagreement (or otherwise to sue the seller for breach of
the MAC rep) unless the definition includes specific objective criteria -- e.g., a specific
dollar decrease in EBITDA or sales, etc.. (Note: as a downsize protective measure, an
expense reimbursement provision should be coupled with the MAC and other closing
conditions.)
9. Don't Give Away the "Basket". One of the provisions sellers generally insist
onin the acquisition agreement is a "basket" to prevent the buyer from"nickel and
diming" the seller for any claims post-closing. The size of the basket varies from deal to
deal, but based on a recent study of the Committee on Negotiated Acquisitions of the
American Bar Association (of which I am a member), the norm is approximately .5% of
the purchase price. If the buyer agrees to a basket, there are a number of significant
issues that it must address, including the following: (i) it should push for a "first-dollar"
basket (sometime referred to as a "threshold") as opposed to a "deductible" so that ifits
damages exceed the basket,the seller would be responsible for all
of the damages (i.e., beginning withthe first dollar); (ii) the basket should only relate to breaches of
representation and warranties and not to covenants or specific indemnity provisions (this
is a common mistake); (iii) any materiality qualifiers in the representations and
warranties should be disregarded for purposes of the basket --otherwise there would be a
so-called "double-materiality" problem(another common mistake); and (iv) there should
be appropriate carve-outs to the basket,the most common of which include capitalization,
due organization, due authorityand ownership of shares.
10. Watch Out for Caps. One of the most important and hotly-negotiated issues
in anyprivate-companyacquisition is the cap (or ceiling) on the seller's damages. Like
other material terms in the acquisition agreement, there is no right or wrong answer (or
"customary" or"market" amount): it all depends on the context of the transaction-- i.e.,
the bargaining power of the parties, the risk profile of the target, the purchase price, etc.
For example, in an auction context with 50 bidders expressing interest in a target, the cap
may end-up being 10% or less of the purchase price due to the competition. On the other
hand, ifthe target has a host of significant problems (and/or is financially troubled) and
there is only one prospective buyer on the horizon, the cap mayend-up being equal to the
- 5- purchase price (or there may be no cap). The lesson here, as discussed above, is that the
buyer must fully understand the target business and the significant dealrisks in order to
make an informed judgment with respect to price and terms, including the cap. Indeed,
as discussed above with respect to the escrow being the sole remedy, if the cap is less
than 100% of the purchase price, the buyer should push hard to include certain carve-
outs, including the seller's breach of (i) any covenants, (ii) specific indemnity provisions
(e.g., environmental, taxes, ongoing litigation, etc.) and/or (iii) certain representations
and warranties (akin to the carve-outs to the basket).
